Value investor with a deep passion for understanding and a desire to improve results over time.
4 Factors That Determine Stock Prices
If you're like most investors, you've tried to anticipate a stock's future price in some way or another. After all, the last time I checked, it was still "buy low, sell high." If you're a value investor, you believe the market is a weighing machine in the long run, as Ben Graham said, and so you follow the company's fundamentals.
If you're using a momentum-based strategy, perhaps you're trying to get a handle on market psychology. With macro analysis and timing, you're trying to understand when bigger trends will affect what you own, and with technical analysis, you're looking predominantly at supply and demand and how the market itself will affect future prices.
All of these approaches have merit in their own rights, but very few people are any good at all of the main ways to invest (show me a deep value investor who also dabbles in day trading, and I'll tell you that person should visit a psychiatrist to diagnose their schizophrenia).
It can seem daunting to try to diagnose the various reasons why a stock might go up or down, but understanding these drivers can help you to invest more intelligently.
1. Earnings and a Fundamental Correlation
A very obvious reason (to a value investor, anyway) is that earnings, or other fundamental business metrics, tend to drive long-term results in the stock market. This means that if a stock has historically traded at a 15 P/E but is now trading at a 10x P/E, and nothing else has fundamentally changed, there might be an opportunity for multiple contraction. This is when the market realizes something is mispriced, just as Ben Graham suggested all those years ago in The Intelligent Investor.
Earnings aren't the only fundamental measure of a company's success, either. Many companies have mediocre or even negative earnings but more than make up for it with positive cash flow. Operating Cash Flow (OCF), sometimes also called cash flow from operations, can be thought of as earnings in terms of actual cash.
The amount of cash a business has to spend can be a great measure of performance, and so can Free Cash Flow (FCF). Free Cash Flow is the OCF number minus any capital expenditures (reinvestment in the company), and it can be a great measure of where a company stands.
For some companies in an earlier stage of operations, still working to grow their business, you might even look at sales over time, as it correlates to the price or the "Price to Sales ratio."
All of these numbers can give you a quick pulse check of the health of the business, and an increase or decrease in any of these fundamental metrics might very well affect a stock's price.
2. The Economy
A stock's price can certainly take a nose-dive if the overall economy is faltering, and it can move up into stratospheric heights (at least momentarily) if there's some really good news about the nation's or world's financial health.
The economy is not the stock market, and that's always worth remembering, but nevertheless, the overall sentiment about stocks, in general, can change quickly when uncertainty about the future crops up. During the Great Recession, the S&P 500 was cut nearly in half from its highs, and while the recovery was steady, it took a really long time to get back to those values (upwards of four years just to break even).
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The infamous Wall Street crash of 1929 anticipated the Great Depression by a hair, but the economy was already slowing down. If unemployment numbers are going up, investors understand that businesses might not be as productive. The economy can be a reason for a particular stock's price to go up or down, especially if said stock is particularly sensitive to borrowing money during good conditions.
Clearly, the elephant in the room (or rather, the 800-pound gorilla) is the Fed. They raise interest rates when the economy tightens, and this means money is harder for companies to borrow.
If that's true, these companies tend to invest less in growth and in the future, making their potential future earnings lower. Naturally, investors think this through, and they're less likely to invest in a company that's not investing in itself, at least when money is cheap to borrow.
3. Supply and Demand
It's a truism to say that all market pricing is a function of supply and demand, but it's only so helpful if you want to understand why there's demand (or limited supply, for instance). However, there are some noteworthy examples of an obvious correlation between the supply of a stock and its demand that are obvious lessons in and of themselves.
The Gamestop Short Squeeze is an instructive saga, wherein lots of investors (many of which were hedge funds and other institutions) shorted the stock of GME in very high numbers, triggering a bunch of retail investors to band together to push the price higher. If you're short a stock, and that stock's price keeps going up, you might need to sell at a massive loss in order to get out alive, meaning the price keeps spiking up.
The Fed also plays a crucial role in supply and demand, but not by issuing stocks themselves. Instead, they control how much money is in the system. Since stocks are measured in money, the amount of money can directly affect the price of stocks.
Consider how the money supply grew COVID-19 pandemic and how this correlated with asset-price inflation, which is to say that stocks got a whole lot more expensive as measured in dollars.
The last of these "four horsemen" of stock price change is even simpler to understand but even tougher to account for: sentiment. Sentiment takes into account all of the other, more technical (or measurable) factors and twists them through the machinery of human emotions.
2021 saw an enormous rise in ESG (Environmental, Social, and Governance) investing, implying that investors have begun to question whether merely making money is enough for them. Instead, people insisted that companies clean up their acts, and many people voted with their wallets by not investing in less cooperative businesses and by pouring fresh investments into companies doing what they feel is the right thing.
Sentiment can also be forward-looking, meaning it takes into account what the Fed is doing with interest rates, how the economy is looking, and where a particular industry might go in the near future. A company can have great fundamentals but terrible sentiment (think oil or tobacco), and even a good contrarian needs to be careful before diving into an industry with strong negative sentiment.
On the other hand, that's when some of the best returns are made. Consider how sentiment ties in with all of the other factors and amplifies or tamps down the effect of the other factors.
This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.
© 2022 Andrew Smith